The Euro crisis and the new impossible trinity

The search for solutions to the euro crisis is based on a partial diagnosis that overemphasises the lack of enforcement of existing fiscal rules. Europe’s leaders should rather address the euro area’s inherent weaknesses revealed by the crisis.

At the core of euro-area vulnerability is an impossible trinity of strict no-monetary financing, bank-sovereign interdependence and no co-responsibility for public debt. This Policy Contribution assesses the corresponding three options for reform: a broader European Central Bank (ECB) mandate, the building of a banking federation, and fiscal union with common bonds. None will be easy.

The least feasible option is a change to the ECB’s mandate; changing market perceptions would require the ECB to credibly commit overwhelming forces, and the ECB is simply not in a position to make such a commitment

The building of a banking federation, meanwhile, involves reforms that are bound to be difficult. Incremental progress is likely, but a breakthrough less so.

This leaves fiscal union. It faces major obstacles, but a decision to move in this direction would signal to the markets and ECB a commitment to stronger Economic and Monetary Union. One possibility would be to introduce a limited, experimental scheme through which trust could be rebuilt.

40 thoughts on “The Euro crisis and the new impossible trinity”

“The immediate gut reaction to Friday’s news is also a reminder that the crisis and its resolution are taking place in parallel universes. Angela Merkel’s comment that the EU should now quickly complete the fiscal treaty is a typical example of that disconnect. No matter what happens, fiscal discipline is their answer. The crisis response fails to recognise the overarching role of the private sector in the eurozone’s internal imbalances. The conclusion of the fiscal treaty, which is the top priority of EU politics right now, is at best an irrelevant distraction.”

Munchau’s article is good, Paul Krugman also noted when discussing the S&P downgrade the continuing tight focus of Angela Merkel and her enablers on the problems that affect the psyche of the the average CDU voter in Germany rather than the economic problems that the EU is actually facing:

One hopes that Merkel’s now officially detached from reality status will see her stock suffer in the way of the unmissed Jean Claude Trichet but it may well be too late to avoid a messy Eurozone break up.

This piece by William Pfaff is from 2005 and is a must-read in the current context where political union is being discussed as a solution to a financial crisis with the ECB in a central role. Note the great US model ref as well.

“The rejection surely demonstrated the current gap of comprehension between European political elites and the European public, but was mainly evidence of the consistently underestimated forces of national identity and ambition in each of the twenty-five nations. The French were enthusiastically seconded by another highly nationalistic and individualistic Euro-pean society, the Netherlands—also one of the founding states of the European Union.

Not only the French and the Dutch (and obviously the British, who have now postponed a referendum that almost certainly would have rejected the constitutional treaty) are opposed to the constitution—or to be more exact, to the form of European integration, and the intention of further EU expansion, that the constitution embodied. ..

…Baverez also speaks of the problem of Europe’s “organized deflation, which has transformed ‘euroland’ into a desert of unemployment and innovation,” the result of Germany’s original insistence that the European Central Bank be given as its sole task the prevention of inflation. This automatically canceled the possibility of Keynesian policies (even the perverted Keynesianism of Bush administration deficit finance, which gives George Bush’s and Alan Greenspan’s America its much-envied growth and high employment). As Robert A. Levine, former deputy director of the Congressional Budget Office, wrote recently, “The rigid monetary and fiscal constraints imposed by Maastricht are at least as responsible for economic malaise as structural sclerosis is.”5 French voters remember that France’s postwar growth, from the early 1950s to the oil shocks of the early 1970s, took place under a dirigist government’s successful industrial policy, by which the government both supported and protected industries that showed a strong capacity for growth. At that time monetarism was but a cloud on the policy horizon, not the fading orthodoxy it is now. “

Some people don’t like seeing ourselfs lab rats , although I accept it was always the way.
Europe has simply not carved a credible fairy tale yet – Bulls$£t is important I guess.
A Bankocracy awaits – where exponential functions are no longer thought in our Universities.

The authors are trapped by their own assumptions. They assume there are only three options:

“I have assessed the corresponding three options for reform – a broader mandate for the ECB, the building of a banking federation, and fiscal union with common bonds – and I have argued that none is easy. Economic, legal and political obstacles make all three difficult. ”

They then spring their own trap on themselves and get into difficulties such as:

“From a German perspective such a choice could therefore only make sense as an investment into the sustainability and the stability of the euro area. For Germany to agree on making such an investment, firm guarantees from its partners would inevitably be required, starting with the acceptance of a surrender of budgetary sovereignty.”

ER, no thanks, Angela. Or what’s sovereignty without budgetary sovereignty?

The pervasive view among europhiles is that what is wrong with the euro project is its not strong enough and thus we have the rather narrow and limited options presented above.

Consider the view the problem with the euro is that we have had too much euro too soon?

Countries like Ireland are a good example of how Europe was unprepared and remains unprepared for the euro.The options we should be considering lie in the opposite direction to those considered above.

What we should be considering are means to back out of the currency; while retaining its principle benefits.

One way of doing this is to return to a puntnua but to negotiate a deal with eg Germany to either purchase a form of eurobonds designed with conditionality alluded to by the writers above; and/or a deal with eg Germany for the purchase of Irish treasury bonds.

This would allow the construction of a free trade agreement based on a floating exchange rate.

Of course the whole mess of current obligations eg /ELA/promissory notes would have to be agreed.

One basic principle underlying any such negotiations would be a deferred payment system for debt; repayments should have extended maturity dates, but would also only be contingent upon generated surpluses following the reaching of agreed budgetary deficit goals.

I hope the thoughts above can remove some of the cobwebs in the europhile thought processes above. Creative thought paths europhiles appear too confined to consider need a lot more work 🙂

To quote Stark in this morning’s IT, “it is an illusion to think that monetary policy can solve large structural and fiscal problems in the euro zone”.

It is equally an illusion to imagine that there is any solution to the euro bubble other than to correct the political behavioural problems which gave rise to it. At least, in this respect, Merkel is right. The only problem is that she excludes Germany from any responsibility.

Why don’t they simply require a operating reserve like with the insurance companies. Just make certain that it cannot be used against the company by some raider, corporate or governmental. And further, make certain that such funds don’t sail under many flags in the accounts. Then you’ll get far beyond anything these idiotic political ‘solutions’ spawned by that un-holy alliance between the French and German Right. If say a 20% reserve was sloshing about within the European economy the place would be a fortress.

It must be really galling for the (high(ish) profile) economists who can see so clearly what needs to be done but the politicians behave like such dunderheads. Why can these politicians not take this wonderful advice that is so freely given and act upon it? What is wrong with them? Can they not see that disaster looms?

The politicians are not stupid – they operate in response to incentives and subject to constraints that don’t seem to enter into the economists’ models. What the politicians know only too well – and what many, of not most, of the economists who pronounce on these matters seem to ignore, or, perhaps, forget – is that for any policy (or change of policy) to be implemented it must secure the informed consent of a plurality of their voters. And the securing of informed consent can be a messy, unpredictable and drawn-out process. Incorporating it into the economists’ neat and ordered models is probably difficult or impossible. These models tend to be based on individuals and firms as rational, dessicated, calculating machines with governments intevening to ensure these calculating machines can achieve their objectives efficiently. Just think of the effect of introducing messy democracy in to these models.

Probably best to ignore it, hold one’s nose and pronounce with authority and clarity.

Unfortunately, this is of little use to the politicians. In relation to the Euro crisis many are starting from ‘square minus one’ with their voters – having previously lied to them and persuaded them that the institutions and procedures supporting the Euro project were bullet-proof, nothing could go wrong, it was all really complicated and they had no need to worry their pretty little heads. Now their deceptions and failure to secure democratic legitimacy are coming back to haunt them – and all, at some point in the future, are desperate to secure re-election.

The economists of course are trying to be helpful – well, at least most of them are – but, I suspect, from the perspective of politcians, they are just trying. It might be more useful if the economists were to turn down the volume a bit, reflect on the theory and analysis on which their pronouncements are based and consider if it may be modified in some way to reflect the political realities which the politcians are confronting.

Now that would be something that might be genuinely in the public interest. But I’m not holding my breath.

@DOCM: “It is equally an illusion to imagine that there is any solution to the euro bubble other than to correct the political behavioural problems which gave rise to it.”

Absolutely spot on! That would be Governments are restricted to spending only what they can garner in tax – zero deficit budgets (for day-to-day spending). But that might make them almost unelectable.

The Euro problem – if that what folk want to call it, is the complete inability of a FIRE type economy to generate sufficient income surplus to repay the compounding debt caused by the unregulated emissision of credit. Its the maths lads – and those pesky expos again.

How many times have you to be warned about this before the cent clinks? Continuously it would appear – but to no avail. You want to exit this mess? Extinguish the unpayable debt – all together, at the same time. That won’t happen. Death by a thousand downgrades.

‘It might be more useful if the economists were to turn down the volume a bit, reflect on the theory and analysis on which their pronouncements are based and consider if it may be modified in some way to reflect the political realities which the politcians are confronting’

You are looking for a critique of orthodox neoclassical economics within the discipline itself. Given that orthodoxy generally serves the existing elites, especially the bankers, there is huge internal, institutional resistance to that. The profession is captured at the highest levels, such as journal editors, Ivy League professiorships and privately funded thinktanks. The MMTers and Post’Keynesians etc are kept firmly outside the main tent. They are heretics and subversives.

Change might happen, like in 1968, when enough trained cadres are unemployed, and interdisciplinary barriers come under attack. Unfortunately the individualistic ‘consumer choice’ ‘end of history’ ideology has been hard-wired into the graduate population, so they have been vaccinated against critical thought, and collective action. The political leaders are. of course, subject to the workings of the same ‘marketing’ ideology.

The thing about the Euro mess is that it is all more or less imaginary. They could sort it out by lunchtime if they really wanted to. Wall of money, sieve the banks into the duds and the ones that survive, debt haircuts, euro investment bank, that sort of thing. Bring in Super nanny. Then start all over again. But power shenanigans get in the way.

What the mess does show is how the climate crisis is going to work out. No action until it’s too late. No unity. And in this case there won’t be any reset button.

Doubt we’ll get any engagement here. This, for example, is Colm Harmon responding to one of my rants on another thread: “I actually glaze over at all references to economists/neoclassical/doctrine/left-right etc!”

Let’s keep it pure…Oh well.

@seafoid,

It’s democracy, I’m afraid, in all its messy glory. Most economists struggle to deal with it and their paymasters absolutely detest it. Having been forced to rebuild it from scratch, Germany has a model democratic system. The other northern European states have continuously renewed and revised their systems to ensure the design and implementation of policy secures democratic legitimacy. Some failed to secure it for the Euro project – and that, primarily, is why the Danes and the Swedes remain outside. Now they are trying to re-secure it – in the most difficult circumstances.

France has always been a law unto itself in these matters and the Brits instictively dislike any of these utopian European concepts that might supplant the lingering legacy of empire. And as for the PIIGS..governments exercising almost total executive dominance captured by narrow sectional economic interests.

Incredibly muted reaction so far this morning btw, lot of yields actually tighter on the day, Portugal the only one getting sold off (and its getting whacked in fairness, got kicked out of some big bond indices this morning).

@Brian
I was thinking of a future bank papacy & how it would control society in a much more determined fashion. – it may be nessary to prevent simple but vital knowledge from leaking out.
Just give the plebs the adding ,subtraction & division thingy.
Parabolic & hyperbolic curves is also a no no.

Can’t get access from where I’m sitting to see what equity volumes are like today but judging from the (lack of) activity and the coffee room talk in the company I’m with today, I get the impression that everyone’s just sitting on their hands, waiting to see what happens next/waiting for someone else to make the first move.

Is there a possibility that some bond market participants realise that, if they keep forcing the pace, popular support for nasty, xenophobic, nationalistic, populist elements will increase and they might end up holding the balance of power in a number of countries? Assuming that many major bond market participants want Europe to be a safe home for ‘good money’ – which it isn’t now, they might have to be resigned to the inevitable imperfections, price them in (sensibly) and cut the politcos some slack to sort things out.

A quote from the above:
“Looking at all this, we also need to wonder how much longer, and why in the first place, Britain is perceived as a safe haven, with its sovereign bonds – gilts – much sought after. Sure, Britain has its own currency and central bank, it can “print”, it can do QE 1001, but it’s not as if it hasn’t already tried that route. And still lost 20% of GDP.”

& a fiscal union where countries with high taxes and efficient tax collection transfer their citizens money to pay for public services in low tax countries where tax collectors appear to be easily avoided & the spending appear to be protected from scrutiny? Politicians aren’t always bright, but they’ll recognise that as a policy that will kill a political career.

There’ll be tax-harmonisation before there is a transfer union & since tax-harmonisation is off the table I see no possibility of a transfer union.

The impossible trinity identified by Pisani-Ferry is about as useful as that identified by Danni Rodrik in the political sphere i.e. not very because impossible to prove.

Indeed, in the case of the EU, the unique structure underpinning it could be said to be designed to disprove the thesis advanced by Rodrik i.e. that it is impossible to combine democracy at a national and an international level in the context of an acceptance of globalisation.

Unlike in a classic federation, the member countries of the EU are, for the main part, the executors of federally adopted policies, not any central federal authority. Many commentators fail to grasp this fundamental point.

The citizens of Europe seem to have no problem with it but the national
politicians do e.g. the present furore in Ireland with regard to their failure to deal with the issue of EU set standards for septic tanks.

There is no technocratic overnight solution to this crisis. The first step has to be to reach a (belated) consensus with regard to the real causes. Commercial imbalances are the main culprit, combined with irresponsible bank lending. These imbalances stem in large measure from the attempt to combine a single currency with an incomplete single market.

Some years ago (2010), Monti, with experience as both Commissioner for the single market and competition – the two key areas – addressed the IIEA ahead of the presentation of his report on the Single Market (which he was commissioned by Barroso to write). The report quotes Delors; “Nobody can fall in love with the single market”. Europe – politicians, policymakers and citizens alike – will have to develop a passion for it if the EU is to prosper.

“Economic and Monetary Union, as mentioned in previous chapters, has a
weakness in the insufficient degree of single market and competition at play in many Member States. They made the bold decision to share the same currency. That requires, at the very least, a high degree of sharing effectively a single, integrated, flexible market, a prerequsite for an optimum currency area and a vector for improvements in productivity and competitiveness. The Eurogroup should make a point in calling all its participating Member States to achieve at least the degree of actual embracement of, and compliance with, the single market and competition that occurs in non-Eurozone Member States”.

Euro 3 to 4 billion being bruited as the amount required for bail outs by the talking heads on US business TV networks. It is far from clear if EFSF was downgraded because it fell short of having enough funds to rescue the over indebted sovereigns or if it is likely to default on the meagre amount it can use. A combination of both is possible since under funding EFSF will lead to collapse.

From the Telegraph website just now: “European governments have signed a “mutual suicide pact” by imposing fiscal austerity plans that will collapse their economies, Joseph Stiglitz, the liberal economist, has warned.”

Strong words.

Talking to some Herr PR Guys and Monsieur PR Guys in the past couple of days, the Euro-spin is about to heavily promote the word ‘growth’ over the next few weeks but expect it to be more talk than action or concrete plans as none of our dear European leaders actually have a clue how they are actually going to make it happen (but they want to be heard to be saying the right things e.g. “Europe will focus on a plan for growth”, “Our priority is growth” and other totally meaningless statements like that from Merkozy, Rumpy-pumpy, Monti, etc.).

What word on Greek PSI discussions? I’ve heard the words “credit event” raised in the past 24 hours. I wonder…. hard to believe that the USA is going to let that happen.

If the ECB is willing to take losses on their Greek Bonds which they have purchased, why were they so insistent in their opposition to Ireland forcing losses on investors of bank bonds?

If it is the case that each Central Bank takes a hit proportionate to their capital contribution to the ECB and there is a large body of ECB council Members who accept that the ECB should take a hit in the event the Greek government introduce Collective Action Clauses, what is stopping the Irish government from taking unilateral action regarding the outstanding promissory notes as well as any senior bank debt that is outstanding?

On unilateral acts on the senior bank debt, the ECB takes no hit and the 3 year LTRO for Eurozone banks acts as backstop against contagion impact as Eurozone banks liquid for short to medium term. There is no unsecured senior debt market for any peripheral bank, imposing losses on senior bonds in Ireland unlikely to radically alter that position.

On the promissory note, the liability could be shared proportionate to the capital contribution of each central bank, €27 billion, similar to Greece’s €50 billion sovereign debt notes, likely purchased at average 50% to 65% of face. As we know, the ELA funding provided through the Central Bank of Ireland to IBRC, with the promissory notes as collateral, is provided through a letter of comfort from the Minister for Finance effectively guaranteeing the funding and the consent of all 23 governing council Members. As Ireland can no longer meet its debt obligations, similar to Greece, either more lending from Eurozone Member States through ESM/EFSF shall be required or Ireland will have to engage in debt restructuring similar to Greece.

While the then Minister for Finance gave a legal guarantee in order to avail of the ELA from the Central Bank of Ireland, the Greek state guarantees to private investors when they issued sovereign bonds and they are about to change the rules due to the unsustainability of their debt position. Removing €27 billion and €20 billion in deferred interest payments from the sovereign without hitting sovereign investors in the process would hugely improve Ireland’s chances of returning to the international bond markets and thus reducing our dependency on official sector funding and providing a success story for the Eurozone.

Greg Mankiw points to the uncelebrated recovery in the United States. It’s not difficult to contrast the United States’ determined action to avert disaster with the Eurozone’s bizare dissembling and spin.

“President Rajoy and I fully share the view that a reform agenda based on fiscal austerity alone is not enough. We need to focus also on growth and job creation. Growth friendly consolidation and job friendly growth are what we need! ”

Expect more meaningless/empty/frequent statements about ‘growth’ coming from a European leader or institution near you soon. Full on.

I am not so sure! The wind has changed direction with the S & P downgrade as the basis for its report is that the approach defended by Germany – that the crisis is solely attributable to budgetary profligacy – is fallacious.

Sarkozy is clearly on the back foot. The EFSF may well have escaped for the moment but S & P have now also downgraded by one notch various public utilities in France. There is a real cost for France, the most significant being a political one; the loss of “parity of esteem” with Germany.

Le Monde has a good report, including the spat that Sarkozy provoked with a Reuters correspondent who dared to raise the issue in Madrid yesterday.

The new “impossible trinity” consists of Merkel, Sarkozy and Monti (especially since the last-mentioned drifted from the true religion in his FT interview).

It’s a bit early to call the situation in the US a recovery. Bond yields are at rock bottom and the corporate sector is sitting on $1.6 trillion IIFC in warehoused capital because they don’t see any worthwhile investment opportunities. The more optimistic in the market are saying the US is pulling way from risk on/off mode but a few months of sub 150K non farm payroll numbers would have the gloom back again sharpish. It’s going to be very volatile for the next few years and if the EZ gets into real trouble all bets are off for the US.

The “default” talked about by Fitch (and yesterday S&P) is a technical reference, ie a distressed exchange. Read the full transcripts and not cheap headlines (I blame the media, not you, though you should know this better than most). For the record, I reckon I was among the 5% max to listen to the actual audio of S&Ps comments, as opposed to the awfully transposed headlines.

@ Mickey Hickey

Re EFSF

“if it is likely to default on the meagre amount it can use.”

How would it default at this point? What are the statistical odds of a AA+ default?

Of course the fiscal pact & associated misguided obsession with gov budgets is nothing more than an attempt to put lipstick on a pig. The Euro is a mess by design, & the same thinking has informed the failing polcies of the last 4yrs.

There is nothing constructive coming from mainstream economics & the political leaders are too incompetent to notice.

What I find glaring in omission from this author’s paper, and, naturally entirely missing from the continuing neo liberal narrative, is any aknowledgement of the growth killing austerity, mass unemployment & the cumulative massive loss of wealth generation in the real economy. The latter being being the only source of wealth.

Ignoring what is ocurring the real economy of ordinary working (& unemployed) citizens, I find morally repugnant. In economics terms, I find the lack of any credible policies to create the growth, that would vastly reduce the severity of the debt issues, to be pure stupidity & intellectual bankruptcy.

So here is one option that is readily implementable which would rapidly restore growth & employment at zero cost to ‘taxpayers’.

Instruct every Eurozone state to develop a Job Guarantee program for every person unemployed who wishes to work (ie it’s voluntary), full time, at minimum wage. Something along the lines of Ireland’s previous Community Employment schemes, programs would be designed to ensure minimal displacement of existing employment in private or public sector, whilst aiming to have some socially useful dimension. (Not rocket science.)

The point is not so much what these JG workers do, rather the optimal boost to aggregate demand when they spend their wages into the economy. Their spending thus stimulates the private sector to meet that rising demand. JG workers then transfer to those new jobs incentivised by wages offered above minimum wage.

The JG programs are financed by new money issuance by the euro issuing authority – the ECB. Debt free, no ‘cost’. Governments will be allowed to retain the savings made in reduction of social welfare budgets, to restore vital lost services to citizens thru’ austerity & further enhance the restoration of aggregate demand. (I could care less what the Maastricht treaty says – it’s a piece of neo liberal nonsense & the ultimate authority over our currency rightly lies collectively with the people of the eurozone & their democratic representives. It needs to be rewritten to properly represent the sovereignty of those interests.)

There is little or no more inflation risk (virtually none anyway) in adopting this means of returning to use all the productive capacity made idle since 2008, vs any other means of regenerating & regaining this capacity in the real economy. (Although the casino operations of the bloated & feral financial sector also needs bringing to heel.)

In restoring growth, the public debt issues of Euro states would become manageable & allow sufficient time for the fundamental flaws of EMU to be properly addressed & resolved. MMT & functional finance principles should be the basis of the reform. Economics that can operate, democratically, in the interests of the majority, not just the few wealthy elites.

At the earliest opportunity, consideration should be given to removing the burden of lending that governments took on purely to bail out failed banks & prevent a euro wide banking crisis. Ireland in particular has €60B debt at least that it should not be responsible for.

If the Eurozone refuses to reach agreement on the above, Ireland should repudiate its ‘odious’ debt, return to its own currency & apply the strategy above itself.

It is disappointing when the real world does not live up to the economic models in which so much mistaken confidence is placed. Sovereign risk was mis-priced because the markets misjudged the nature of the single currency and the main weakness in its construction.

Heiner Flassbeck overstates his case but the core of his argument is sound and is, indeed, shared by Martin Wolf.

To the various impossible trinities can be added a very possible one; that of business, organised labour and government.

It is paradoxical that Sarkozy is now trying to play catch-up with his “social summit”, the core elements of which are (i) an increase in VAT by 2% to (ii) lower employer costs coupled with (iii) a scheme to compensate for short-time working on the model of the German “Kurzarbeit”. This is exactly the formula hit upon by Merkel some years ago. It also implies, of course, acceptance by France of the inevitable downturn, if not recession, which is looming but a hope that France will emerge on the right side of the equation.

There area also reports that the CDU and the FDP are in negotiation to agree a basis for the introduction of an FTT at the level of the euro area with agreements possible in March (!).

Meanwhile, in its December communication regarding VAT, the Commission formally abandoned the objective of arriving at an origin system for VAT in intra-Community trade.

“The realisation of the single market in 1993 resulted in the abolition of controls at fiscal frontiers. To achieve this, the Commission proposed moving from the pre-1993 “destination based” system, where VAT is effectively charged at the rate of VAT applicable where the buyer is established, to an “origin based” system, with VAT being charged at the rate in force where the supplier is established. This would have effectively abolished fiscal frontiers within the EU.

This was, however, not acceptable to Member States as rates of VAT were too different and there was no adequate mechanism to redistribute VAT receipts to mirror actual consumption”.